Friday, March 28, 2014

An imagined Q&A between the Mayor of Seattle and a local reporter about inequality in Seattle -

Reporter:     Mayor Murray, you've established an
                    Inequality Committee to consider a 
                    $15/hour minimum wage in Seattle . . . 

Mayor:        Yes, that's right.  We’re determined to reduce the excessive inequalities of wealth and income in Seattle.

Reporter:     Well, if you’re really serious about reducing inequality, then why is the Seattle City Employees’ Retirement System planning to triple its investment in Private Equity?

Mayor:        Private Equity?  You mean the sort of thing Mitt Romney was involved in?

Reporter:     Yes, Private Equity is the province of the very wealthy, and Private Equity investors enjoy one of the most unjust loopholes in the Federal tax code.

Mayor:        Which loophole is that?

Reporter:     It's the so-called "carried interest" loophole that allows Private Equity investors to pay lower tax rates than most Seattle workers pay.  (See here and here).

Mayor:       That is unfair!  But the City of Seattle can't do anything about the Federal tax code.

Reporter:    Well, not directly, but Private Equity firms hire lobbyists to preserve this tax break, and Seattle invests money with these firms. (See here).

Mayor:        OK, I take your point.  But the Seattle Retirement System must act prudently, not politically, when it invests.

Reporter:    Yes, of course, but did you know that the Seattle Retirement System's largest investment in Private Equity, a $20 million bet on a Private Equity firm located in the Cayman Islands, is now worthless? (See here and here).

Mayor:       All investors make mistakes.

Reporter:    Granted, but according to the Retirement System’s own website (here), Seattle's Private Equity investments have underperformed their benchmark by 7.5%/year over the last five years, and by 1.5%/year since April 2007.  And these figures don't even include the high fees charged by Private Equity firms.

 Mayor:       (Sigh) That's depressing.  Have you talked the Retirement System's private financial advisors about this?

Reporter:    Oh, they love Private Equity.  But then they get much higher fees when Seattle invests in actively managed funds like Private Equity.

Mayor:        So, the upshot is that, by getting out of Private Equity, Seattle can make better investments and strike a blow against the unjust tax loopholes that benefit the very rich.

Reporter:     Well, many economists, including several Nobel Prize winners, think so. (See here).

Mayor:        Perhaps I should talk with Councilmember Licata; he's the Chair of the Seattle City Employees’ Retirement Board.

Reporter:    You’ve both said you want to address

Sunday, March 16, 2014

The Wonderland of Long Ago, Before Macroeconomics Was Invented

In reviewing a paper that revolves around a New-Keynesian DSGE (Dynamic Stochastic General Equilibrium) model, Axel Leijonhufvud reminisces, “It makes me feel transported into a Wonderland of long ago – to a time before macroeconomics was invented” (I mentioned this passage in my last post). But, Leijonhufvud quickly concedes, “One has to recognize, of course, that DSGE practitioners of a New Classical persuasion feel that it would have been altogether better if macroeconomics had not been invented” (emphasis added).
         These provocative observations are worth exploring. Let’s begin with Axel’s conception of economic theory before “macroeconomics was invented.”  This is the “Wonderland” of pre-Keynesian economics where supply and demand are brought into equilibrium by the price system, which, in its most imaginative incarnation, assumes the form of a centralized auctioneer who assists in bringing the conditional intentions of all market participants into harmony before trading begins.
When brought to bear on the unemployment problems of the 1920s and 1930s, the orthodoxy, stripped to essentials, said that if workers are unemployed, it’s because wages are too high. Firms won’t hire additional labor at the going wage if the marginal worker’s value added is less than the prevailing wage. This view became “pre-Keynesian” after Keynes explained why lower wages wouldn’t restore full employment (at least not without a great deal of unnecessary suffering). Keynes granted that lower wages would increase employment, provided everything else remains constant. But it doesn’t. If, as the orthodoxy holds, prices equal marginal costs, and if marginal costs consist predominantly of wages, then falling wages must lead to falling prices, leaving real wages more or less unchanged (i.e., not much help on the cost side of the business ledger). In addition to this unavailing dynamic, there’s also the problem that if total wage payments fall, then sales of wage goods will almost certainly fall too (i.e., no help on the revenue side of the business ledger).
At first glance, it looks as if Keynes is offering a GE critique of a Partial Equilibrium analysis, drawing attention to the fact that falling wages in the labor market will spill over into the goods market where both prices, and revenue from the sale of wage goods, will decline hand-in-hand with the reduction in wage rates and in total wage income. These self-defeating effects of wage cuts could be avoided if every agent’s plans were brought into harmony before trading began. Indeed, compared to the circumstances of massive unemployment, real wages might well be higher if plans were brought into harmony before “the market opened.”
Although Keynes’s assumed the interconnectedness of markets, he was not, of course, a Walrasian. In fact, both the Treatise and the General Theory can profitably be read as inquiries into the nature of economies in which the plans of market participants are not pre-reconciled before decisions are taken. In the General Theory, the equilibrium level of employment doesn’t represent a coherent fitting together of plans, nor is the equilibrium reached by a process of t√Ętonnement or re-contracting. Rather, it’s the total employment chosen by profit-maximizing firms given their estimated costs and expected sales revenue. And, of course, there’s nothing in this arrangement that assures resources will be fully employed.

We’re now in a better position to appreciate Leijonhufvud’s complaint about DSGE models. They conceal from view the coordination problems that plague actual economies, where the plans of households and firms are not pre-reconciled before decisions are made. In most of these models, there’s no way in which a reduction in spending can simply become a reduction in income, no possibility that a rush of deleveraging will become self-reinforcing, in fact, there are no troublesome positive feedback loops at all. To conclude with Leijonhufvud’s own words, “Representative agent constructions that do not admit fallacies of composition [e.g., the Paradox of Thrift] thereby eliminate from the models the major sources of instability in the economy.”

Thursday, January 9, 2014

The Emperor’s New Clothes: Economists’ Models and Stories

There’s been a spirited debate on the Econ Blogosphere over the merits of models and stories in understanding economic phenomena. It began with Stephen Williamson’s post, “Liquidity Premia and Monetary Policy,” in which Williamson wrote down some equations and derived a counterintuitive result.

There were several objections to the post (Nick Rowe), (Brad Delong), and (Paul Krugman), but the most interesting was the criticism that Williamson’s model lacked a narrative about the decisions “real people” would actually make and how these decisions would interact to produce the equilibrium outcome derived in the model.  In reply, Williamson offered the following defense, “Equilibrium is often a very convenient way to think through all of that, and all of us sometimes use wording about what the economy ‘needs’ or ‘requires’ [to reach equilibrium] as shorthand.”

When pressed further, Williamson acknowledged that “the stories about convergence to competitive equilibrium - the Walrasian auctioneer, learning - are indeed just stories . . . [they] come from outside the model” (here).  And, finally, this: “Telling stories outside of the model we have written down opens up the possibility for cheating. If everything is up front - written down in terms of explicit mathematics - then we have to be honest. We're not doing critical theory here - we're doing economics, and we want to be treated seriously by other scientists.”

The most disconcerting thing about Professor Williamson’s justification of “scientific economics” isn’t its uncritical “scientism,” nor is it his defense of mathematical modeling. On the contrary, the most troubling thing is Williamson’s acknowledgement-cum-proclamation that his models, like many others, assume that markets are always in equilibrium.

Why is this assumption a problem?  Because, as Arrow, Debreu, and others demonstrated a half-century ago, the conditions required for general equilibrium are unimaginably stringent.  And no one who’s not already ensconced within Williamson’s camp is likely to characterize real-world economies as always being in equilibrium or quickly converging upon it.  Thus, when Williamson responds to a question about this point with, “Much of economics is competitive equilibrium, so if this is a problem for me, it's a problem for most of the profession,” I’m inclined to reply, “Yes, Professor, that’s precisely the point!” 

Let’s take a closer look.  Stephen identifies “the Walrasian auctioneer” as one of the “the stories about convergence to competitive equilibrium,” but this characterization is, I think, mistaken and revealingly so.  In Walras’s version of GE, market participants submit their conditional intentions to an “auctioneer,” who searches for a set of prices that will bring everything into balance.  But the really crucial constraint with respect to the point at issue is that no trading is allowed until all of these conditional intentions to buy and sell are pre-reconciled in a mutually consistent set of plans. 

This idealized process of t√Ętonnement is very far removed from “the convergence to competitive equilibrium” Williamson envisions.  The difficulty, in brief, is that no one has shown how real-world decisions taken “before” all plans have been harmonized will result in a general equilibrium.  Quite the contrary, Franklin Fisher has shown that decisions made out of equilibrium will only converge to equilibrium under highly restrictive conditions (in particular, “no favorable surprises,” i.e., all “sudden changes in expectations are disappointing”).  And since Fisher has, in fact, written down “the explicit mathematics” leading to this conclusion, mustn’t we conclude that the economists who assume that markets are always in equilibrium are really the ones who are “cheating”?
The other “story” from “outside the models” that props up the GE premise on Stephen’s list is “learning.”  But the learning narrative also harbors massive problems, which come out clearly when viewed against the background of the Arrow-Debreu idealized general equilibrium construction, which includes a complete set of intertemporal markets in contingent claims.  In the world of Arrow-Debreu, every price in every possible state of nature is known at the moment when everyone’s once-and-for-all commitments are made.  Nature then unfolds – her succession of states is revealed – and resources are exchanged in accordance with the (contractual) commitments undertaken “at the beginning.”
In real-world economies, these intertemporal markets are woefully incomplete, so there’s trading at every date, and a “sequence economy” takes the place of Arrow and Debreu’s timeless general equilibrium.  In a sequence economy, buyers and sellers must act on their expectations of future events and the prices that will prevail in light of these outcomes.  In the limiting case of rational expectations, all agents correctly forecast the equilibrium prices associated with every possible state of nature, and no one’s expectations are disappointed. 
Unfortunately, the notion that rational expectations about future prices can replace the complete menu of Arrow-Debreu prices is hard to swallow.  Frank Hahn, who co-authored “General Competitive Analysis” with Kenneth Arrow (1972), could not begin to swallow it, and, in his disgorgement, proceeded to describe in excruciating detail why the assumption of rational expectations isn’t up to the job (here).  And incomplete markets are, of course, but one departure from Arrow-Debreu.  In fact, there are so many more that Hahn came to ridicule the approach of sweeping them all aside, and “simply supposing the economy to be in equilibrium at every moment of time.”
What’s the use of “general competitive equilibrium” if it can’t furnish a sturdy, albeit “external,” foundation for the kind of modeling done by Professor Williamson, et al?  Well, there are lots of other uses, but in the context of this discussion, perhaps the most important insight to be gleaned is this: Every aspect of a real economy that Keynes thought important is missing from Arrow and Debreu’s marvelous construction.  Perhaps this is why Axel Leijonhufvud, in reviewing a state-of-the-art New Keynesian DSGE model here, wrote, “It makes me feel transported into a Wonderland of long ago – to a time before macroeconomics was invented.”

Friday, December 20, 2013

Socialism in One City (Seattle)

Opening the Seattle Times this morning, I was surprised to see a photo of Seattle’s new Socialist Councilmember, Kshama Sawant, standing alongside the City’s new Mayor, Ed Murray, who was announcing the formation of a new Income Inequality Committee.  The Committee will consider minimum wage legislation, which Ms. Sawant would like to set at $15/hour, the level recently adopted through initiative by the City of SeaTac.

The paths leading to a more Egalitarian Seattle are cluttered with obstacles.  A former UW political scientist, Paul Peterson, insists that egalitarian initiatives, "redistribution" in Peterson's jargon, are pursued more effectively by countries than cities.  The title of Peterson’s book, “City Limits,” captures the main idea, which is that businesses and well-to-do residents aren’t trapped within the City’s boundaries; they can relocate to more “hospitable” jurisdictions, as Boeing is threatening to do.

In a more perfect world, minimum wages would be raised in concert nationwide (or worldwide), we’d have a more progressive tax code, and there would be better educational opportunities for less advantaged citizens.  But we don’t live in an ideal world, and so Seattle must seek out the next best alternatives.

There are some egalitarian policies Seattle can pursue without running up against the “city limits.”  Ms. Sawant isn’t the first Socialist elected to the Seattle City Council.  A hundred years ago, the Socialist Party was an active participant in the political battle to create Seattle City Light.  At the time, the existing electric utility was owned by a Boston syndicate and charged 20 cents/kWh.  When City Light started delivering power, it charged 8 cents/kWh, forcing its private competitor to reduce its rate to 8.5 cents/kWh. Now that's public power!

But I digress.  Today, Seattle has a chance to follow the excellent lead of B.C. Hydro, British Columbia’s publicly-owned electric utility.  B.C. Hydro charges its larger customers a carefully designed electric rate that doubles the financial incentive to conserve.  Each customer receives a block of low-cost power based on their past consumption, but pays a much higher rate for additional consumption.  In the long run, this electric rate alternative will reduce total energy costs, which are borne disproportionately by low-income households.  Perhaps our new Socialist Councilmember can nudge Seattle City Light in this progressive direction.

Here’s another question for Ms. Sawant: Do you approve of the City’s Retirement System's plan to triple its investment in Private Equity?  Thanks to the so-called “carried interest” tax loophole, Private Equity owners (remember Mitt Romney) pay a lower tax rate than most City Employees.  Seattle’s Liberal Councilmembers seem content to allow the City’s Private Equity holdings to be sharply increased, even though Private Equity lobbying groups are now pressuring Congress to maintain a tax loophole that benefits the highest echelons of the top 1%.  Surely a Socialist can’t support such investments!

Since I’m gathering up my holiday spirit, let me express the hope that our new Socialist Councilmember will bring the Liberal members of the City Council to their senses on these issues.  More efficient and environmentally-friendly utility pricing used to be a Liberal battle cry in Seattle, and the argument that it won’t work, or will drive business away, holds no water in light of B.C. Hydro’s success.  And if our Liberal Councilmembers can’t be persuaded to halt the City’s indirect support of Private Equity’s “carried interest” tax break, then perhaps their new Socialist comrade will occasionally remind them about the City’s $20 million investment in a Cayman Islands private equity firm, which is now worthless.

(I've created a new blog, "Socialism in Seattle,", in hopes I'll have something interesting to say about the issues raised by Socialist City Councilmember, Kshama Sawant.)